INTERCONTINENTAL JOURNAL OF FINANCE RESOURCE RESEARCH REVIEW AN EMPIRICAL INVESTIGATION ON PERFORMANCE OF GOLD & CURRENCY: BLACK SCHOLES MODEL

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1 AN EMPIRICAL INVESTIGATION ON PERFORMANCE OF GOLD & CURRENCY: BLACK SCHOLES MODEL Dr. CHETNA PARMAR Associate Professor/ Ph.D. Guide, School of Management, R.K. University, Rajkot, Gujarat ABSTRACT Commodity derivatives are not capable mitigate the causes of commodity price volatility but only intend to manage risks liked to the volatility. A study focus on how to predict market price of selected commodities and also how exchange rate affected to the buying and selling of the derivative contract. Black Scholes model indicated variance on bid price and ask price. Researcher found that sustained imbalance of competing bids and offers can drive prices away from theoretically expected values. Imbalances can be caused by factors such as a sudden political event or unexpected news regarding a particular market. These factors cannot be quantified and can have an effect on both gold & currency. Keywords: MCX indices, Volatility, Black Schols Model, Option Sensitivities, Gold Contract, Exchange Rate, Cross Rate INTRODUCTION: The history of Indian capital market in India dates back to the eighteenth century when East India Company securities were traded in the country. Until the end of the nineteenth century securities trading was unorganized and the main trading centers were Bombay and Culculltta. Of the two, Bombay was the chief trading center wherein bank shares were the major trading stock during the American Civil War ( ). Bombay was an important source of supply for cotton. Hence, trading activities flourished during period, resulting in a boom in shares price. This boom, the first in the history of the Indian capital market lasted for half a decade. The bubble burst on July 1, 1865 when there was tremendous slump in shares pricethis lead to a slump in the market capitalism at the BSE by about 20 percent overnight and the stock market did not open for nearly a fortnight. Later come buoyancy in the stock markets when the multinational companies (MNCs) forced to dilute their majority stocks in their Indian ventures in favor of the Indian public under FERA Several MNCs opted out of India. One hundred and twenty three MNCs offered shares worth Rs 150 corer, creating 1.8 million shareholders within four years. The offer prices of FERA shares were lower than their intrinsic worth. Hence, for the first the FERA dilution created an equity cult in India. It was the spate of the Indian stock markets. ROLE OF DERIVATIVES:- The term derivative stands for a contract whose prices is derived from or is dependent upon an underlying asset. The underlying asst could be a financial asset such as currency, stock and market index, an interest bearing securities or a physical commodity. Financial transactions are loaded with several risk factors. Derivatives are instruments in separate from those risk factors from traditional instruments and shifting risks to those entities that are ready to take them. If exchange rate risk is high even though a substantial profit may have been made overseas currency and may erode a significant amount of investment earnings. Interest rate risk is simple the reduction of value of securities and bonds due to the 104

2 rise of interest rates over a given period of time. Commodity price risk arises whenever a movement in commodity prices either positively or negatively, impact on contact financial position. ROLE OF MCX IN INDIA: Multi Commodity Exchange (MCX) is an independent commodity based in India. It was established in 2003, located at Mumbai MCX offers future trading in bullion, ferrous and non-ferrous, metals, energy and number of agricultural commodities. MCX is India s number one commodities exchange with 83% market share in Globally, MCX ranks no.1 silver, no2 in natural gas, and no.3 in futures trading. The highest traded item is gold. ROLE OF MCX-SX IN INDIA: MCX-SX Clearing Corporation Limited (MCX-SXCCL), was jointly promoted by MCX Stock Exchange Limited (MCX-SX), Multi-Commodity Exchange of India Limited (MCX) and Financial Technologies India Limited (FTIL), as a new age Clearing Corporation constituted to undertake clearing and settlement of deals in multi asset classes. The company offers best-in-class services to its clearing members with the help of its state of the art risk management framework and unparalleled clearing and settlement systems with dedicated linkages with clearing partners REVIEW OF LITERARURE: Wing Yan, David Stephens, Sofia Hedging strategies and minimal variance portfolios for European and Exotic options in a levy market Mathematical Finance, Vol 20, no 4, October 2010, It is shown how variance portfolios can be used to hedge the higher order terms in a Taylor expansion of the pricing potentially variance can be used to hedge the higher order terms in Taylor expansion of the pricing function. McKenzie, D Gerace, Z. Subedar An empirical investigation of the Black Scholes model: evidence from the Australian Stock Exchange Australian Accounting Business and Finance Journal. 1(4), Available at: This paper evaluates the probability of an exchange traded European call option being exercised on the ASX200 Option Index. The results also provide evidence that the use of implied volatility and a jump-diffusion approach, which increases the tail properties of the under laying lognormal distribution, improves the statistical signification of the Black- Scholes model. Beckers (1980) tested the Black-Scholes assumption that the historical instantaneous volatility of the underlying stock is a function of the stock price, using S&P index option Beckers (1980) finds the underlying stock is an inverse function of the stock price. Rubinstein (1944) illustrates that the implied volatility for S&P 500 index options negatively skewed and leptokurtic. Jackwerth and Rubinstein (1996) show the distribution of the S&P 500 before 1987 exert lognormal distribution, but since have deteriorated to resemble leptokurtosis and negative skewness. Das and Sundaram (1999) indicate jump-diffusion and stochastic volatility mitigate but do not eliminate volatility bias. Das and Sundaram (1999) identify jump-diffusion and stochastic volatility process does not generate skewness and extra kurtosis resembled in reality. 105

3 DeanTeneng Limitations of Black-Scholes Model International Research Journal of Finance and Economics ISSN Issue 68 (2011) ; Black-Scholes model is considered the biggest success in financial theory both in terms of approach and applicability. This paper explores the weaknesses in this model and illustrates some consideration when dealing with such models. H.Reynaerts & m.vanmaele A Sensitivity Analysis for the Pricing of European call Options in a Binary Tree Model This model is very general in the sense that it can be applied if one describes it by fuzzy numbers in option. The conclusion is that the price option is a strictly increasing function of the volatile An Introduction of Gold & Currency Derivative Market: GOLD: Of all the precious metals gold is the most popular as an investment. Investors generally buy gold as a hedge against economic, political, or social fiat currency crises (including investment market declines, Burgeoning national debt, currency failure, inflation, war and social unrest.) The gold market is subject to speculation as are other markets, especially through the use of futures contracts and derivatives. The history of the gold standard, the role of gold standards, the role of gold reserves in central banking, gold s low correlation with other commodity prices, and its pricing in relation to fiat currencies during the global financial crisis, suggest that gold behave more like a currency than a commodity. CURRENCY: The introduction of Currency Derivatives in India is a landmark decision which is likely to be a boon for importers, exporters and companies with Forex exposure. These Derivative products have a wide scope with their special features tailored to match customer requirements. As Currency Derivatives are new in India, I have taken on the task to explain them in more detail. Currency Derivatives are similar to many other Derivatives, Stocks, and Indices, etc. It is just that the underlying assets of Currency Derivatives are Currencies. The value of the Currency Derivatives. Objective of study: I. First to identify a co-relationship between gold and currency derivatives in Indian capital market with use of black schools model. II. Second, to analyze movement of different currency and gold price. 106

4 Sample universe:- The sampling universe is the total number of items/events from which you can select or sample for statistical analysis and description. Here, MCX AND MCX-SX all indices. Sample unit: For Gold: - gold (10 grams) For currency:- EURO GBP USD CNY Sample period:- Here, An investigation on gold and currency derivatives for 1 year from 1-JAN-2012 to 31-DEC Hypothesis of study:- H0: There is positive relationship between gold & currency. H1: There is negative relationship between gold & currency. Data Collection: I have used secondary data for analysis of gold and currency relationship from MCX, MCX-SX, GOLDRATE.COM, WIKIS etc. Tool of Analysis:- The black schools model is used to calculate a theoretical call option and put option using the five key determinants of an option s price: stock price, volatility, time to expiration, and short term interest rate. The second part of the study will have as core analysis of gold and different currency by the black schools model, which will be studied, given due term of option. C SN d rt E e N 1 d2 PARTICULAR GOLD -USD -GBP -EURO -CNY R 9.25% 9.25% 9.25% 9.25% 9.25% T (3 MONTH) Σ Rf % 0.5.% 1.65% 3.60% 107

5 Upper Limit Lower Limit Bullion is mostly traded in MCX India. Contract value had been fluctuated 2011 to In 2011 value is (in lakh) which reduced in 2012 and reach at (in lakh). Table show that call premium and put premium both are same. Because of spot and excises price difference call premium upper limit is while it lower limit is Table show that from January 2012 to December 2012 call premium was highly fluctuate same with put premium. FOREX CURRENCY: -USD Upper Limit Lower Limit In forex market this - USD is mostly traded currency. Here, same as spot price and exercise price difference call premium upper limit of USD is 6.7 while it lower limit is 4.9 Same with put premium. Table saw in between January 2012 to December 2012 it highly fluctuated and decrease at end of year. -EURO Upper Limit Lower Limit EURO is currency of 17 country of euro zone. In forex market this - EURO is second most traded currency. Here, same as spot price and exercise price difference call premium upper limit of EURO is 8.9 while it lower limit is 6.73 Same with put premium. Table saw in between January 2012 to December 2012 it highly fluctuated and made stable at end of year. -GBP Upper Limit Lower Limit GBP is currency of England. In forex market this GBP is third most traded currency. Here, same as spot price and exercise price difference call premium upper limit of GBP is 9.99 while it lower limit is 7.4 Same with put premium. Table saw in between January 2012 to December 2012 it highly fluctuated and nearly make stable at end of year -CNY Upper Limit Lower Limit

6 CNY is currency of China. In forex market this CNY is rarely traded currency. Here, same as spot price and exercise price difference call premium upper limit of CNY is 1.1 while it lower limit is 0.70 Same with put premium. Table saw in between January 2012 to December 2012 it highly fluctuated and decrease at end of year. Finding & Conclusion The main objective behind selecting this project is to investing the performance of gold & currency & it selected from MCX and FOREX MARKET. Here, from the above chart we can say that our first hypothesis is right for three currencies (GBP, EURO, and CNY) that it have positive relationship with gold. Means when gold prices increase at that time pound, euro, and Yuan have strong. While, our second hypothesis is right for US dollar. There is negative relationship between gold and US dollar. It should be noted that while quantifiable factors can explain much of the observable price behavior, supply and demand still play an important part. A sustained imbalance of competing bids and offers can drive prices away from theoretically expected values. Imbalances can be caused by factors such as a sudden political event or unexpected news regarding a particular market. These factors cannot be quantified and can have an effect on both gold & currency. That being said, theoretical options pricing is a valuable tool that helps investors and traders anticipate price movements for option positions. Options involve risks and are not suitable for everyone. Option trading can be speculative in nature and carry substantial risk of loss. Invest only with risk capital or money that you can afford to lose. References: 1. Rama, Cont, Peter, Tankov, Financial Modelling with Jump processes Chapman Hall/CRC Press, Peter Carr,Liuren Wu, Time change Levy processes and option pricing [Online] August 2002, accessed 3. Stephen P Lalley, n.d. Levy Processes, Stable Processes and Subordinator's, [Online] accessed , 4. Freedman, D, Brownian motion and diffusion Springer-Verlag, NY, 2nd Edition. 5. BLACK. - Fisher. Myron, Scholes The Pricing of Options and Corporate Liabilities. The Journal of Political Economy, 1973, vol. 81, no. 3, pp Baxter, Martin and Andrew Rennie. Financial Calculus: An Introduction to Derivative Pricing. Cambridge, England: Cambridge University Press, Hull, John C. Options, Futures, and Other Derivatives. Upper Saddle River, New Jersey: Prentice Hall, Ross, Sheldon. An Introduction to Mathematical Finance. Cambridge, England: Cambridge University Press,